A couple decades ago I was working as a newspaper editor. We had mainframe computers with desktop terminals. There was no Internet, no cell phones, no lap tops, no flat screens. Our computer monitors were amber, not full color.  Using the best technology available at that time, it took several hours to write the news stories, lay out the pages, run the pages through a printing press and send them to distribution points before anyone could read the information. During that hours-long process, we often got updated information but we were locked in a production schedule and had no way to make timely changes.

Now we live in an instantaneous world. Anyone can write something on a computer (or even a phone) post it on the World Wide Web and someone in China or Australia can read it seconds later. I love today’s free flow of information and ideas. But I think this also skews our opinions, perceptions and expectations. We’ve become conditioned to view our lives in hours and days rather than months or years. This is especially true in investing. Twenty years ago if an average investor wanted to find out the price of a stock during the day, he’d usually have to call a broker to get that information. Trading commissions were high—sometimes 6% or 7%. So investors tended to hold positions for extended periods because frequent trading quickly eroded the value of an account. Today investors have instant access to price quotes and charts. Ordinary investors have ready access to tools and information that only professionals had before the 1990s.

Much of the financial news we hear is sensationalized. Information is presented out of context so its impact and importance can become distorted. For example, based on media reports, many investors might believe that 2010 has been a volatile year for the markets. After all, gold reached a new all-time high and the real estate market continued to slide.

In actuality, 2010 has been a fairly subdued year for the financial markets. For example, the S&P 500 is up about 5% for the year. It was up about 7% in May and dropped to -10% in July. Compare than to 2009 when the index dropped to a -25% loss at one point and then climbed to a 25% gain.

In measuring overall market conditions, one method Strategis Financial Group uses is to assess the relationships among five sectors, represented by five exchange-traded funds (ETFs). These include the S&P 500 (SPX), international stocks (EFA), long-term bonds (TLT), real estate (IYR) and gold (GLD). The chart below shows how these sectors have fared so far in 2010.

As you can see, the top-performing investment among this group has been gold—no surprise because the financial media has been hyping gold all year. What might surprise many investors is that gold is only up 20%. What could be even more shocking is that gold is only slightly ahead of real estate for 2010 gains. IYR made its biggest push from February to the end of April. Since then it has mostly moved sideways.

Although bonds have been sliding since early October, until that time they had performed as well as gold or real estate. For the year TLT is still in third place just slightly ahead of the S&P 500.

EFA did well in October and November, but in July it was down almost 20%. So even with a strong performance in recent weeks, it is barely above break even for the year.

With five trading weeks remaining in the year, it is difficult right now to forecast where any of these sectors are going to finish.  It appears likely that GLD and IYR will close out the year with decent gains. At this point last year gold was up nearly 35% –well ahead of real estate which trailed far behind with a 15% gain. But in 2009, gold dropped 15% in December and IYR gained 10% in the final five weeks. Real estate edged gold for the biggest gains of the year.

With a lame duck Congress, debt troubles all over the globe, high unemployment in the U.S. and the Federal Reserve trying to boost inflation, it is still way too early to write the end of the 2010 market story.
Flint Stephens

Back in late spring of this year, Strategis Financial Group switched a large portion of its client assets to long-term bond funds like iShares Barclay’s 20+ Year Treasury Bond ETF (TLT). For most of the summer we looked quite intelligent because long-term bonds did well. All that changed quickly over the past few weeks as bonds have done a sharp retreat. The irony is that the decline in bonds has occurred when economic fundamentals would seem to indicate that bond prices should be rising.

The chart below shows the performance of TLT over the past six months—about the same amount of time we have been holding bond positions. The chart includes three other positions we use to help us assess overall market conditions: International stocks (EFA), Real Estate (IYR) and the S&P 500 Index (SPX). As the chart shows, throughout the summer months, bonds drifted upward as the other investments bounced around without making any real progress. In August bonds soared and the other three positions slid.

When September came, the three equity investments began rising while bonds struggled to hold their ground. Now take a look at the next chart. By the end of September, technical indicators were starting to show that the upward move in equities was reaching an overbought level where the risk of a downturn was increasing. This chart shows the S&P 500, but the other two stock positions were in a similar condition. The pink highlighted portion of the chart shows that the current rally is similar to the one that occurred earlier in 2010 that was followed by a significant correction. We currently believe that a similar correction is a distinct possibility.

The middle portion of the chart is a moving average convergence divergence (MACD). This indicator is usually reliable at identifying market turning points. By the end of September, it reached an overbought level and the MACD actually crossed below its moving average—something that typically precedes a market correction. As shown in the blue highlighted oval, this indicator is still at an overbought level. Again this indicator looks much like it did earlier in the year prior to a correction.

The bottom portion of the chart shows a stochastic oscillator. It reached an overbought level in early September. This indicator was showing that the move in stocks appeared to be overextended and ripe for a corrective downturn. The green highlighted areas show that prior to the summer market correction it generally remained above the 50 level ever since, never completing a normal downward cycle. It has done virtually the same in this instance.

The bottom line is that in October, our indicators were showing that a stock market downturn was likely. They still are. A downturn in stocks would normally propel long-term Treasury bond prices higher again. As a result, we have been reluctant to move into stocks because there is a probability that a correction will follow and the price of bonds will again rebound. So while we looked smart for several months, the past month has made us look like we quickly lost IQ points. We still anticipate that this situation will right itself. Unfortunately, the move to do so could occur tomorrow or it might not happen for several weeks.

Using perfect hindsight, we wish we had moved out of bonds at the end of August and switched to international or U.S. stocks, but at the time that seemed imprudent. As a result of this experience, however, we have made a change to our Focus Growth Strategy, which is fundamental to the way we deal with market rotation. In addition to the positions shown in the first chart, we have added commodities such as precious metals to our selection set. Like stocks, precious metals positions currently appear overbought and overdue for a corrective move. But going forward we believe that having that option will better enable us to manage market rotations.

Another factor that made the recent bond move so difficult to manage is that the Federal Reserve is actively manipulating the bond market in an attempt to stimulate the economy. Normally it does that by lowering interest rates. When rates fall, bond prices tend to rise. When the Fed began buying bonds in August, interest rates declined and bond prices spiked.

Last week Federal Reserve Chairman Ben Bernanke announced the Federal Reserve’s intent to purchase $600 billion in Treasury bonds. Bernanke said the decision to buy bonds came about because the Federal Reserve has already lowered its lending rates about as much as possible. Bernanke said the massive bond purchase was expected to drive interest rates lower. One would anticipate that dropping rates and buying competition for bonds would drive prices up. Instead, the exact opposite has occurred and no one seems to know why. As an example, here is a passage from an article in Thursday’s Wall Street Journal:

“Having such a big, unflinching buyer in the market should keep prices high and yields low.

“But the opposite has been happening lately. A Treasury auction of $16 billion in new 30-year bonds on Wednesday was poorly received, with the government having to pay a slightly higher yield than expected to attract buyers.

“The 30-year Treasury bond’s price has fallen nearly 12% since Aug. 26, just before Fed Chairman Ben Bernanke hinted at QE2 in a speech at Jackson Hole, Wyo. The yield has jumped to 4.239% from 3.53% in that time, and at one point on Wednesday surged to the highest since May.

“And Treasurys have weakened despite fresh fears about European sovereign debt, which in the past has been a boon to safe-haven U.S. government debt.

“The weakness in the 30-year bond is not terribly surprising. The Fed has said it won’t buy much 30-year debt. It stuck by that commitment in Wednesday’s schedule, dedicating just about 4% of its purchasing power to longer-dated bonds.

“Still, the 10-year Treasury note, which will get much more Fed attention, has suffered, too. Since Aug. 26, the 10-year note yield has risen to 2.657% from 2.50%.”

The same article quotes David Ader, chief government bond strategist at CRT Capital, who said he fully expects the situation will right itself once the program is underway. A schedule released by the New York Fed reported that buying will begin Friday, Nov. 12, with purchases of $6 billion to $8 billion. By Dec. 9 the Fed plans to have purchased about $105 billion in Treasurys.

In the meantime, the situation remains uncomfortable for those like Strategis who are holding long-term Treasury bonds. For the time being, we remain the goat. But if the bond-purchase program works as it should, we might again be the hero.
Flint Stephens

Wednesday the Federal Reserve took the unusual action of pledging to purchase $600 billion in U.S. Treasury bonds by the middle of 2011.  Then in another unusual move, Federal Reserve Chairman Ben Bernanke explained the Fed’s actions in an op-ed column in the Washington Post on Thursday.

Bernanke explained that the Fed has a dual mission of maintaining high employment levels and low inflation rates. He wrote that in spite of prior attempts to stimulate the economy, “the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.”

Moving on to inflation, the chairman explained that “most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. Although low inflation is generally good, inflation that is too low can pose risks to the economy - especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.” In other words, Bernanke said that right now Federal Reserve officials feel a need to boost inflation rates.

The important question is whether buying bonds will help the Fed solve these two problems. Obviously Bernake believes it will. But there is already some pretty good evidence that this move is not likely to work as intended. Traditionally the Fed stimulates the economy by lowering interest rates. But Bernanke noted that short-term interest rates are already about as low as they can go, so the Fed had to use another method to support the economy.

Again quoting Bernanke, “This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

He does not comment on the fact that mortgage interest rates have been at historically low levels for a lengthy period but so far that has done little to bolster housing sales. Bond rates have likewise been low for some time, yet businesses have not taken advantage of those low rates to expand. Stock prices have been rising, but many economists and analysts believe that current stock valuations are already too high and a further escalation of those prices will just lead to a bigger correction at some point in the future.

Bernanke also did not comment on the impact this policy will have on the U.S. Dollar.  As he explained, in summer the Fed indicated its intent to begin buying bonds and actual purchases began in August. Below is a chart of Powershares U.S. Dollar Index (UUP), an ETF that trades the dollar. Notice how the dollar began falling about the same time as the Fed indicated it would begin purchasing bonds. The day after Wednesday’s announcement, UUP broke below a key support level

A declining dollar is a double-edged sword. It makes U.S. goods cheaper in overseas markets, stimulating exports and lowering the trade deficit. That can be good for U.S. business. But a falling dollar drives up the cost of imported goods, meaning consumers are likely to see rising prices for many items. At the same time, a weaker dollar is less appealing to foreign investors so they are less likely to invest in U.S. Treasuries—a key market in recent years for financing U.S. debt.

And while Fed officials are concerned about low inflation, there are indications that many are already worried about the prospect of rising inflation. Most investors are familiar with the recent rise in gold prices to record highs. Silver has shown an even bigger gain and these metals are frequently used as hedges against inflation or as protection from a failing economy.

Below is a chart of JJA, an exchange-traded note that seeks to replicate the performance of a basket of futures contracts on physical commodities like corn, soybeans, wheat and soybean oil. In general, commodity prices have risen sharply over the past five months. JJA is up more than 50% during that period.

Prominent measures of inflation like the Consumer Price Index often exclude food and energy. Yet these categories make up a significant portion of the expenses of most families. If the prices of basic commodities rise, corresponding retail prices will also go up. Maybe Bernanke is not aware, but people who go to the grocery store or to gas stations know they are already paying more than just a few months ago. And this latest action is likely to substantially increase inflation, just like Fed officials are hoping.

Out-of-control inflation is devastating to consumers in general, but it hits especially hard those portions of a populace already struggling like the poor or elderly who are on fixed incomes. In his column, Bernanke wrote: “Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation. Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.”

Others might be less confident that the Fed will be able to regain control if things get out of hand.

When I was a teen, I spent one summer doing some work that required driving a farm tractor. One day I started driving down a steep hill. Very quickly I realized I was going too fast and I needed to slow down to negotiate a turn at the bottom of the hill. I pushed in the clutch to shift the tractor into a lower gear, just like I had done hundreds of times while driving cars. But a tractor isn’t a car and as soon as I pushed on the clutch the tractor increased its speed and I could not get it back into gear. I stomped on the brake with all my might as the tractor hurtled toward the turn at the bottom of the hill. As I went around the corner, I felt the big wheel on the uphill side rise off of the ground. For an instant I thought the tractor would tip and I might not survive.  But the wheel slammed back down and I was finally able to regain control as the tractor found level ground.

Intentionally trying to increase inflation—whether of retail prices, wages, or stock prices—is traversing a slippery slope. The real danger is not that it won’t work, but that it might work too well. Given the Federal Reserve’s lack of recent success in fulfilling its dual mission, it is difficult to believe that this latest act of desperation is going to solve any problems. What the chairman described as a “virtuous circle” could just as easily turn into a vicious circle.

Flint Stephens